Fundamental reforms of over-the-counter (OTC) derivatives markets around the world are having a profound impact on how derivatives are used, raising particularly challenging questions for sovereign institutions, according to a BNY Mellon report.

In the report, titled Sovereigns in Search of Solutions: OTC Derivatives Reform: Direct and Indirect Impacts, BNY Mellon explores inherent inconsistencies in the application of key OTC reform provisions and the potential impact on sovereign institutions, a base of increasingly influential global investors that use capital markets and OTC derivatives for implementing their investment strategies and hedging exposure.

The core objectives of the proposed reforms, which include The Dodd-Frank Wall Street Reform and Consumer Protection Act, the European Market Infrastructure Regulation (EMIR), and similar measures throughout Asia Pacific, are to centralise and manage counterparty credit risk and increase transparency.

The evolving and inconsistent regulatory framework raises important issues for sovereigns regarding their obligations and the potential cost of compliance.

“Sovereigns are generally regarded as low risk counterparties, and as such have not generally been required to provide collateral,” says Jai Arya, head of BNY Mellon’s sovereign institutions group. “With global regulatory reforms, however, precisely what is in and out of scope with respect to sovereigns remains murky. The classification of sovereigns and subsequent variation in Basel III capital adequacy rules must be addressed to avoid market distortions and regulatory arbitrage. In addition, the cost of compliance to the new rules could potentially hit sovereigns - and those servicing sovereign counterparties - very hard.”

The report notes that the continuing debate over “extraterritoriality”, defined as the applicability of a set of rules outside the direct jurisdiction of the overseeing regulator, adds further complexity.

European sovereigns have generally expressed concern over the potential impact on counterparty selection as a result of the proposed Dodd-Frank Act’s extraterritorial scope, for example. The de facto exclusion of US financial institutions as potential counterparties could have a very negative impact on derivatives pricing, liquidity and risk management.

“We expect that a common approach will be reached between the major strands of regulatory reform to avoid market distortions and regulatory arbitrage, but inconsistency and conflict between national and supranational rules persists,” says Nadine Chakar, head of Derivatives360 , BNY Mellon. “Until a consistent framework of exemptions from both capital adequacy and clearing requirements across jurisdictions may be agreed, sovereigns may find that their OTC derivatives activities become subject to mandatory clearing.”